Do firms anticipate security issues by conservative reporting?

Abstract

We examine the importance of debtholders’ and shareholders’ concern for conservative accounting. We use the concept of conditional conservatism and study a firm’s earnings behavior around important capital structure decisions, i.e. debt and equity issues. We employ a large sample of US debt and equity issues, which allows us to investigate the timing of conservatism. Our results show that firms issuing equity exhibit increasing conservatism in the period preceding the issue, driven by the demand of shareholders in the public markets. This finding is consistent with the notion that managers signal credibility to the market in an attempt to improve issue terms. We obtain weaker results for the role of conservatism in issuing debt, which is inconsistent with the idea that financial reports are primarily meant as a governance mechanism in debt contracting.